Seth Wunder on Hyper competition in the Hedge Fund World

Richard Kramer: Welcome to Bubble Trouble, conversations between the economist and author Will Page and myself, independent analyst Richard Kramer, where we lay out some inconvenient truths about how financial markets really work. Today, we're in conversation with our sixth special guest, discussing hypercompetition in the hedge fund world. More in a moment.

Welcome back, and I'd like to welcome Seth Wunder to our show. Seth, welcome.

Seth Wunder: Thank you. It's good to speak to you guys.

I started my career in the late '90s, originally joining Morgan and Stanley as a equity analyst in the mutual fund business. And I was fortunate enough at the time to get thrown into the, uh, tech bubble, if you will, and covering all s- different types of tech media, telecom companies who were coming public back in that period.

I then spent the next four years at two different mutual fund companies, both Morgan and Stanley and OppenheimerFunds, and then, in 2004, I had an opportunity to join hedge funds, also as an equity analyst. And so from 2004 all the way through to 2021, I've been at various different hedge funds, first as an equity analyst, then as a, a co-portfolio manager, and then over the last five years running my own fund as well. And throughout that period of time, most of my focus has been in innovation-oriented themes across tech media, telecom, and then sp- spilling into the rest of the economy, as tech has obviously permeated everywhere.

So, I recently left the hedge fund business, and I joined a tech company as the chief investment officer in the fin-tech space.

Richard Kramer: Mm-hmm [affirmative]. So, you've seen plenty of bubbles.

Will Page: Do you have enough fingers on both hands to count the number of bubbles that you've seen in those two decades?

Seth Wunder: It- I mean, I've read so many books, too, goin' back to like the 1500-1600s.

Will Page: [laughs]

Seth Wunder: So, yeah, I, I got 'em all.

Will Page: Well, I- I'm just interested in this journey that you've been on. And I'm sure Richard will take it from where you are now, but just... When you looked at the credit crisis kicking in 2006-2007, exploding by 2009, what were your reflections on there, that point when f- where liquidity dried up? I mean, as a hedge fund operator, were you caught in the crossfire of that one?

Seth Wunder: Yeah, you know, there's a couple of different things in that. First off, we were focused on tech companies at the time, and so you're tryin' to understand what the spillover effect is to the... to the general economy. I've always had the saying that I try to impart on analysts that work for me, and it's certainly relevant to that period of time, which is, you know, when things are good, they're usually far better than you think they can be, and when things are bad, they're far worse than you could imagine.

Will Page: [laughs]

Seth Wunder: And the reality is is, you know, that was one of those periods where, like, you, you sorta knew something bad was gonna happen, but you really didn't appreciate how bad it was gonna be.

The biggest issue that we had, though, more broadly, if you look at the hedge fund business, or just investors in general, is i- you always have a disconnect in time. If you look out over 10 years, things are fine. But when you think things are fine over the next 18 months and your investors aren't comfortable with what your definition of fine is, you've got all sorts of problems. And I think that's where the illiquidity mismatch really caught up with a bunch of funds. I think people in the hedge fund space really ended up unscathed but learned a ton, uh, and, and hopefully I took a lot of that with me in the... in future endeavors.

Richard Kramer: So, one of the themes we've been exploring, Seth, has been hypercompetition and this notion that when there are very low barriers to entry, everybody dives in. And I think, i- i- like you've tau- Will talked about the fingers and toes last time. I've lost count of, of the sheer number of hundreds of tech hedge funds out there that've either gone through the birth-death cycle or been born and are still going today. How do you think about the nature of competition among investors for figuring out which of those few dozens of prized tech stocks are gonna drive all the performance?

Seth Wunder: Yeah. You know, the competition in the market has changed so dramatically in the last... really 10 years, but, you know, I could go on for longer than that.

It's not just that there's a plethora or too many hedge funds, e- particularly, let's say, long-short equity funds focused on the same tech stocks and so forth. It's that the overall market competition across various participants has changed dramatically too. I mean, when I started my career, you know, I'll never forget, the first portfolio manager worked for... And, you know, he used to yell at me every day when the market would open, like, "Why is this stock up 5%?" or, "Why is this stock down 6%?" And, and you'd make a few phone calls or you'd figure... you'd call the company or... and you'd realize that they presented at some conference and some fundamental news was put out in the market, and the people who paid attention early enough to that really moved the stock. And it was sort of a human-to-human combat, you know.

And now we've gotten into the situation where the stock market opens and a whole swath of companies will be up 3% to 5% [inaudible 00:04:37], and it'll be on nothing. A- and it'll be because some computer algorithm decided to rebalance its exposure to growth or value or interest-rate sensitivities or shortage risk, and so on and so forth.

So, the competitive set is not just long-short equity funds. The problem is is that there just aren't that many high-quality companies. And you know... and so when you look at the nature of where we're investing, we probably can all pull together the most amazing 15 tech companies that exist out there. And so if you don't own them, you sort of miss out on returns, and if you do own them, then you just have this generic portfolio that everyone has.

And so when you've got 1000s of funds chasing, let's say, 25 higher-quality ideas, there's a crowding mechanism that happens and, and we all end up sorta looking fairly generic and consistent, but... We can unpack that more, but it- it's a crazy dynamic with the number of people chasing the few ideas that are out there.

Richard Kramer: Seth, certainly you have one experience which I'd, I'd love you to reflect on, which is... I- I wouldn't say going activist, but getting heavily involved; prodding a company to change itself that had underperformed dramatically. And do you think a fund manager is in a great position to force a, a, a company that should know its own business better than anyone to really change how it functions? You have to question whether, in some cases, the managers are just looking for a quick return as opposed to doing something that, that, that management may have taken a lot longer to achieve.

Seth Wunder: So, it's a delicate balance. Well, you can go back through the public disclosure. So, in 2017 we released a, a bunch of letters and, and interactions with Etsy at the time. It was a very collaborative experience for me, you know, having met with the board and management teams and so forth. So, I have most... utmost respect for how they changed some of the processes inside the company. It really created a tremendous amount of value.

Richard Kramer: Mm-hmm [affirmative].

Seth Wunder: I, I think the, the fine line is that most people who are in the hedge fund space who take that sort of activist or the [inaudible 00:06:32] suggestivist role, you know, they're really doing it from a pure value-creation standpoint. Like, "We want you to spin off this underperforming business, and we want you to, uh, buy back shares. We want you to lever the balance sheet." And yeah, those all have, like, that quick-fix aspect to it, and then I think it does a disservice to companies over the long term.

But I do think that there's a purview of broadness that you have by sitting in the investment community where you can see what best execution looks like. And when you're looking at a company that could have a great end market and a great value proposition and maybe isn't executing at the... what's called the efficient frontier of where they could, I think if you can be helpful in a way that's constructive, it goes a long way.

And, and so what I know from talking to companies, whether investor relations or CFOs, and now being at a company, uh, myself... what you realize is that that top 1% of investors that really know what they're talking about are wonderful to collaborate with, and there information flow goes both ways. It's the rest of 'em that have lots of opinions; sort of seem a bit misguided. A lot of companies operate and they myopically execute to what they think is in front of them, and if you can sort of expand their horizon a little bit and show them maybe some best ec- operations or best practices that you've seen from other companies, yeah, there's a space for that, and it should be done carefully.

I had a good experience with it, I th- I believe the company had a good experience with it, and, given the opportunity to do it again, I certainly would. But I do see other press releases and moments come about where hedge funds are asking for some sort of dramatic change, and you could look at it with a skeptical eye and realize that they're just generating some fees and want... and want a quick return. And I guess everyone has freedom of speech, but, but that's not the way we've approached it.

Richard Kramer: I- I've always thought that being an analyst and understanding the company means you have to be able to, as if you were working at the company, understand what's realistic for them, as opposed to being a 20-something kid who says, "Okay, smarty pants. Just sell this division." Well, you know, there might be 10,000 people and jobs and livelihoods involved and, and a lot of other stakeholders and considerations that that 20-something-year-old won't ever consider, and it's just not realistic to ask a management to take a snap decision like that.

Will Page: Just peeling back for a quick second there, those references that Seth gave us about short-termism just reminds me of going home to Edinburgh and meeting James Anderson, the chief investment officer at Baillie Gifford, and asking him, "How's the fund management industry today?" He's like, "It should hold its head in disgrace because they're selling at the peak and they're buying at the trough. Your job as a fund manager is not to arbitrage opportunities. It's to fund successful businesses." Very simple thing to say, but very easy to forget, and it's... it sounds like that problem is rearing its head again at the moment as well.

I feel like a student with two professors on this podcast, but I remember learning the [inaudible 00:09:04] beauty contest at university, and I always apply it in media. And I'm just wondering whether there's room to apply it here, which is, if I'm asked to judge three beautiful models as to which one's gonna win, I use my judgment call. But if I'm asked which of these three beautiful models is going to win based on the judges view, I put my mind in the heart of the judges to work out what they're thinkin'. So I'm no longer thinking for myself, I'm thinking, "How do judges call this one?" That applies to financial markets, and it must apply in a special way given you've got algorithmic trading, retail trading exploding.

So kind of hold my hand and walk me through this one. Who are the judges, and do the judges still have the influence that they once had?

Seth Wunder: So, that point is... should be taken into two different angles, and I think they're both super important.

So, first off, when you're researching a company, the self-bias that people have is sometimes overwhelming, right? So, first of all, the judge should be the customer. You know, you may not like Twitter, but if millions of people do-

Will Page: Right.

Seth Wunder: ... well, then they, they must be doing something right. So, first of all, when you look at a company, you got to objectively look at, like, what they're accomplishing, who their customer is, and put that in its place, as opposed to just your own opinion. But when you look at the market, you know, the thing that I think people forget, a- and I've forgotten too over a period time, is that stocks are just a function of supply and demand. And we could academically say something is overvalued and, and all these other good things, and, and, and w- we read all these books, but it's supply and demand, and today demand is a function of lots of different factors, computers being one of them.

You know, probably the biggest demand-driver in the market today is ESG. You know, look at... like, Tesla's stock is up, I think, 55% or 60% in the last 30 days. It's very hard for me to have anyone justify how $500 billion of capital has been created in the last 30 days, but we're in a very ESG-driven world, and so that capital is going to flow to the largest company associated with that trend.

And I think, when you look at stocks, there's this idea of understanding, like, what's the narrative and what's going to get people to buy versus what's going to get people to sell? And it's like what I said earlier, the beauty contest used to be judged by fellow humans, and if you felt like you knew more than, let's say, 95% of your competitors, you, you knew who would be buying it after you. Now, today you got to be cognizant of all the other things that are out there, which is why I think the hedge fund business and th- the asset management business is under so much, uh, stress, because there are participants and, and influences that go beyond what I think our natural judgment is.

Richard Kramer: We should move to wrap up this first half because there's so much stuff we want to unpick in, in part two, especially the future of this asset management industry. Because you constantly hear the trope that these hedge fund managers are the titans bestriding the world and that asset management is this perpetual growth industry, but you've raised some critical points about whether it's gonna be humans or computers that are gonna be leading that charge in the next, uh, decades.

We'll be back with Seth Wunder, Will Page and myself in part two.

Will Page: Back again with part two of Bubble Trouble, this time in conversation with Seth Wunder, exploring the hypercompetition in hedge fund management. And you'll pick it up from where we've just come off there. I- I- I'm interested to see these two, you know, experts in their field unpack one conundrum for me, which is I watched the debate between should your money in a tracker fund with low fees or a star fund manager with high fees, and it swings. If we all believe in tracker funds, well, that creates an opportunity for our star fund manager. If we all believe in star fund manager, that creates an opportunity for a tracker fund. The pendulum swings, but it swings back again. With the introduction of algorithmic trading and retail trading and Robin Hood-type platforms, is it swingin' out of control?

Richard Kramer: The question I've got for Seth is is it inevitable that markets get overheated? And maybe we don't want to use the word bubbles, but is it inevitable that markets are prone to this sort of overheating, overexuberance, or w- w- we just are naturally and human seeking that novelty? Are markets the same way? Are we always gonna be looking for the asset class that no one knew about that we're the clever guy who's discovered?

Seth Wunder: 1,000%. I mean, I look at it as the cross section of capital availability and lack of regulation, you know. And, and when you sit in that cross section, you're gonna get... I wouldn't say bad actors, you're just gonna get greed. Whether it was back in the tech bubble 20 years ago, which was a function of certainly easy capital, stock options were fervorent, payment to management teams was a function of pumping and dumping stocks, and that obviously blew up in a somewhat historical, glorious way...

Now, you've got a couple of things. You've got the gamification of trading platforms. You've got the cross section of, let's say, the SPAC market, and obviously we'll see where crypto ends up. But crypto might be a very wonderful technology for a long period of time, and there's lots of things I certainly like about it, but it's clearly an under-regulated asset class at the moment.

So, yeah, I think it's human behavior that people are gonna chase returns until they're told that they can't, and then there'll be something else in the future. How that unwinds, though, it will be different, but e- we've seen this... we've seen this before. You know, Alan Greenspan famously said in Irrational Exuberance... I'm pretty sure it was in the beginning of '97 or the end of '96. The NASDAQ didn't peak until March 2000. So you, you, you, y- I- if the head of the Fed says something's irrational and you've got another three and a half years before that actually comes home to roost, well, we might be having this podcast conversation again in the next two, three years and still calling it Bubble Trouble.

Will Page: What you're describing here seems to be a bit of a structural change in finance, and I'm often fond of saying that, in tech, next year's curriculum at universities is already out of date. There's a new tool; a new facility; who's teaching Google BigQuery today, because that's going to be huge tomorrow. That, that type of how-do-you-keep-pace-with-the-market, do you ever worry that students studying finance today are studying a market that's already been displaced by what you've been describin' for the past 15-20 minutes?

Seth Wunder: Yeah. You know, uh, I've thought about that a lot.

Will Page: It's crazy, right? Who's coming out the university gate to enter this market, and what tools do we have, and are those tools relevant?

Seth Wunder: Y- you're baiting me into being an ageist, which I don't really wanna be, but, but the reality is is that there is definitely a cohort of people who just don't believe in, like, the basic fundamentals of finance. [inaudible 00:15:13] think about the idea that, like, there's cash flows, and there's credit, and there's equity, and, like, that circular triangle is unbreakable, except for when you input this other thing called the Fed, and then they just decide that, like, they wanna keep the machine going.

So, it- it's allowed for this imagination to, to go to a place where, like, yeah, fundamentals of finance don't matter anymore, and I think it would be s- foolish to say that, like, things can't change. But I do think there's a cohort of investors, and it's not even just the kids in college. I mean, there's kids in high school, who are trading this stuff around the world, who just have a different perspective of how financial markets work. And quite frankly, you know, they may be right, and maybe it's a generational shift and we all just have to be cognizant of it. And it goes back to the point earlier: the influences of what causes stocks to go up or down are very much driven by factors beyond fundamentals at this point.

Richard Kramer: Seth, you're a student of history. Wasn't it always thus that we never knew what the fundamental value of Mississippi land or Dutch tulips or, or any of those things were? In the Roaring '20s, they had a bunch of stock promoters giving you the i- i- the functional equivalent of snake oil, and there was so little information. Now, we have so much better information, but that doesn't prevent people from getting wildly unmoored from intrinsic value.

Seth Wunder: History is not on the side that things have changed.

Will Page: Just think about this for a second: in four years time, you'll have people studying in uni- economics at the age of 16 at school who have never lived in a period where interest rates exceeded inflation. Inflation is now at 3.5%; interest rates are rock bottom. That thing that you told would never happen again has been happening now for 10-12 years. It's crazy.

I've got to get you on the basketball court real quick. Hot hands: the idea that if I can get the ball in the basket once, twice, three times, surely I'll get it in a fourth time. But, of course, probability has no history, and can you kind of blend the hot-hands fallacy into this discussion we have here, our belief in predicting the future? Where's the bubble trouble in the hot-hands fallacy here?

Seth Wunder: Well, what I worry about is when people are playing hot hands with, like, just the market as a general construct. I wouldn't say it's fine, but at least conceptually it's sort of fine, right? Like in the sense that, like, when the market goes down, there's tons of liquidity, you can change your mind, the, the chances that the market goes down 30% or 40% is... th- those happen, right, but they're probably not financially ruining if people are properly diversified or have enough money that they could afford the risk.

The hot hands problem happens now where people are just moving themselves way out on the risk curve and they're putting a tremendous amount of their personal wealth into... whether it be alt coins, or penny stocks, or all these other suspended-belief assets. And the problem is, if you study history, as we were just talking about, those things go down like 90% or 95%. I mean, p- you, you get wiped out. And it's human behavior, right? You make a little bit of money in the... in the S&P 500, and all of a sudden you try to make a little bit of money in a, a 500-million-dollar alt coin deal because the return volatility is higher and it- it's fun.

The best, best, best hedge fund managers get like 52% to 54% of their picks right. You know, the idea is is that, like... and if I stick with the baseball analogy, it's about slugging percentage, which is are you hitting doubles and triples in the baseball game? Hopefully, the biggest positions I have, with the most amount of capital behind, I'm getting those right at like a 65-70% clip.

So, if the people who are living and breathing this every day are getting just marginally above 50% right, you know, I think the idea that, like, the masses could just do a lot better... I mean, maybe they can, that's not to say that they... that they can't, it's just statistically, like your point on probability, yeah, I don't think anyone in general is going to bat much above 50%, and it's probably a fool's errand to think if you've been on hot hand to, to keep rolling that dice. Eventually, it's gonna catch up to you.

Will Page: Y- your, uh, baseball analogy gets lost on the Scotsman because we just do not know the rules of that, but with basketball I can try and twist it. It's almost like, "If I get it right the first time, I get it in the hoop the first time, and I take two steps back, I'll still get it the second. If I take three or four steps back, I get it the third. Maybe I can get it from the halfway line." And it's like that self-belief that if we all have a party over in the tech sector, that's gonna be one huge party worth havin'.

Seth Wunder: Yeah. Well, look at, like, a free throw, right? If you wanna stick with baseball, like, the best free-throw shooters shoot, you know, 87% to 91%. You know, you back up, what, five, six feet to the three-point line, and then all of a sudden that percentage drops down to like 45%, right? So it doesn't take a lot of distance to see your, uh, accuracy go down precipitously.

Richard Kramer: I think there's th- th- another analogy, just to draw to that, with your hedge fund manager point, is, you know, it's not about scoring a lotta points when you're up by 30. It's, it's about whether, when the game is on the line, you know you can make the shot. And what you're saying is when the hedge fund managers have conviction and they put a lotta capital behind something, those are the shots they need to get right-

Seth Wunder: [crosstalk 00:20:04].

Richard Kramer: ... whereas you have... you always have a long tail in your portfolio that may or may not come good, but that's not where your capital is concentrated; where your big bets are.

Seth Wunder: I always try to tell people, like, you know, if you sell a stock at, you know, at point X and it goes on to go, let's say, 30% higher, and then it comes down, you know, on the other side of that mountain and then you sell it on the other side, whether you sold it now before the all-time high or sold it after the all-time high, the same price is the same price, right? But there's a point where you assume too much risk and things can go wrong. So, like, you know, selling winners and taking gains and being right and putting money in your pocket is not a bad strategy.

Richard Kramer: So, one of the things we like to do to wind up all of our Bubble Trouble episodes is pu- point out a couple of smoke signals. What are the kind of things that, for a generalist audience, you'd want to warn people, take note, keep an eye on? The kinds of things that you want to bear in mind to avoid falling into bubble trouble. So, what are a couple of smoke signals, when you hear someone say that, you oughta just take a step back and, and say, "Calm down for a sec"?

Seth Wunder: Oh, I think it's really easy. I think the narratives that a normal return might be in the hundreds of percents is when you have to start to step back and say, like, "Okay, something that's really wrong here." I mean, I- I went to lunch [laughs] yesterday with a old friend of mine who's starting a crypto-oriented fund, and, and I swear th- he said, "I think my fund is gonna be a 5x in the first year." I didn't want to spit my food out, but I was just... I was shocked that he could say that.

So, I, I don't mind if, like, you know, my 12-year-old daughter has an opinion on a stock and she's just learning things, and she's like, "I heard this from a friend." Like, yeah, I realize that probably 12-year-olds probably shouldn't have a ton of opinions on stocks, and so that, that raises my tentacle.

Will Page: [laughs]

Seth Wunder: But if she starts to say things like, "Dad, we can double or triple our money in, you know, Dogecoin," you know, that's where I-

Will Page: [laughs]

Seth Wunder: ... I really get uncomfortable. So, that's the big one for me.

I think the other one is just universal confidence. I- it's very unsettling to start committing capital where people have an undue level of confidence, where i- it just... it almost is like a religious belief, and so y- you just have to have your, you know, eyes and ears up to things like that.

But i- it's great that people are participating, and, by the way, everyone should participate. And it's wonderful that information's been democratized, and everyone should have an opinion, and if nobody wants professional advice, they don't need professional advice. All that stuff's great. W- w- when people are over their skis in, in confident and speed and return expectations is when things go wrong.

Will Page: Over their skis.

Richard Kramer: Yeah, that's what, uh-

Will Page: [laughs]

Richard Kramer: That- that's why the, uh, orthopedic surgeons love the, uh, sport of skiing, because they know that a certain number of people [laughs] will end up at the bottom of the mountain with a need for r- knee reconstruction.

Seth Wunder: Yeah.

Richard Kramer: One other point I'll make is... and, and, Seth, we were talking about this on a previous podcast, how this whole SPAC trend is... you know, the notion of, "Give me money for an idea I haven't had yet," and, and just the, the level of confidence that the SPAC promoter has to have that they can go out and find an investment that they may or may not have any competence in, in judging, and that you're abrogating that responsibility and handing it to somebody else, is pretty staggering and certainly something that you'd expect regulators would pay a little bit more attention to.

Seth Wunder: You, you missed the key point there: "Give me money for an idea that I haven't found yet. Oh, and by the way, pay me an enormous fee for my imagination." It's fascinating.

Will Page: That takes us to the end of this week's Bubble Trouble. I want to thank Seth Wunder for, uh, for comin' in from LA for this call. Uh, for Richard Kramer. Two experts in finance chewing the fat on a topic which won't go away. Uh, a lot to take from here.

Richard Kramer: If you're new to Bubble Trouble, we hope you'll follow the show wherever you listen to podcasts.

Bubble Trouble is produced by Eric Nuzum, Jesse Baker and Julia [Nat 00:24:00] at Magnificent Noise. You can learn more at bubbletroublepodcast.com. Will Page and I will see you next time.